Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His most recent book is Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System.
Europe’s Vicious Spirals
11 January 2012
BERKELEY – The euro crisis shows no signs of letting up. While 2011 was supposed to be the year when European leaders finally got a grip on events, the eurozone’s problems went from bad to worse. What had been a Greek crisis became a southern European crisis and then a pan-European crisis. Indeed, by the end of the year, banks and governments had begun making contingency plans for the collapse of the monetary union.
None of this was inevitable. Rather, it reflected European leaders’ failure to stop a pair of vicious spirals.
The first spiral ran from public debt to the banks and back to public debt. Doubts about whether governments would be able to service their debts caused borrowing costs to soar and bond prices to plummet. But, critically, these debt crises undermined confidence in Europe’s banks, which held many of the bonds in question. Unable to borrow, the banks became unable to lend. As economies then weakened, the prospects for fiscal consolidation grew dimmer. Bond prices then fell further, damaging European banks even more.
The European Central Bank has now halted this vicious spiral by providing the banks with guaranteed liquidity for three years against a wide range of collateral. Reassured that they will have access to funding, the banks again have the confidence to lend.
Cynical observers suggest that the ECB’s real agenda is to encourage the banks to buy the crisis countries’ bonds. But that would only further weaken the banks’ credit portfolios at a time when European regulators are desperate to strengthen them. The ECB’s decision to provide the banks with unlimited liquidity does not solve governments’ debt problems, nor is that its intent. But it at least prevents the debt problem from creating banking problems, which, in turn, worsen the debt problem without end.
Europe’s second vicious spiral runs from fiscal consolidation to slow growth and back to fiscal consolidation. Tax increases and cuts in public spending are still needed; there is no avoiding this reality. But these demand-reducing measures also reduce economic growth, causing deficit-reduction targets to be missed. Getting fiscal consolidation back on track then requires more spending cuts, which depress growth still further, causing budget performance to worsen even more.
At some point, recession and unemployment will provoke a political reaction. Angry electorates will boot out austerity-minded governments. And uncertainty about what kind of governments come next will not reassure investors or positively influence growth.
Interrupting this second vicious spiral will require jump-starting growth, which, under current circumstances, is easier said than done. The external environment is not favorable. Economic growth in the United States is still weak, and growth in emerging markets seems poised to slow.
So what are Europe’s policymakers to do? Restarting growth requires a two-handed approach that addresses both supply and demand.
Consider first the supply side. Research on the European economy has shown that small and medium-size enterprises (SMEs) are engines of employment creation. But SMEs need credit in order to grow and hire, which underscores the importance of the ECB’s recent steps to restore liquidity to the banking system.
The other supply-side measures will have to be taken by governments. The Italian parliament, for example, has agreed to remove limits on store-opening hours as a first step toward liberalizing the retail sector. But taxi drivers and pharmacists have successfully resisted efforts to open their professions and make provision of their services more flexible and efficient. The need to placate such interest groups is a serious obstacle to jump-starting economic growth, because comprehensive reform is more effective than piecemeal reform.
Getting all of the stakeholders to go along will require compensating losers. And here Europe’s social model can be an asset rather than a liability. The losers from reform can be provided generous but temporary unemployment benefits. They can enroll in government-funded, industry-organized training schemes. European governments that promise to aid the losers are more likely to retain political support. They will be better able to stay the reformist course.
Likewise, taxi drivers will be more agreeable to the award of additional medallions if demand for their services is buoyant. Hence the continuing need for demand-side measures, which puts the ball back in the ECB’s court.
Cutting interest rates will not be enough. Pushing up asset prices and pushing down the euro’s exchange rate will require the ECB to buy bonds on the secondary market – not the crisis countries’ bonds per se, but those of all eurozone members. In other words, it will require quantitative easing.
Nothing is guaranteed. But Europe can still escape its vicious spirals if everyone does their part.